Lecture 2

International Trade

International Trade
Theory (2)

Prepared by Eka Puspitawati, PhD

Department of Economics
Universitas Pertamina
2024
 Topics to be discussed
⚫ Interdependence because of trade
⚫ Absolute Advantage
⚫ Specialization
⚫ David Ricardo: Comparative Advantage
⚫ The benefits of trade
⚫ Production possibilities without and with
trade
⚫ The basis and gains from trade
In this lecture, look for the answers
to these questions:
⚫ How can trade make everyone better off?
⚫ Why do people – and nations – choose to
be economically interdependent?
⚫ What is absolute advantage?
What is comparative advantage?
How are these concepts similar?
How are they different?
Interdependence
Every day Veil from
you rely on Turkey
many people
from around Blouse from
the world, Ohio, US
most of whom
you do not Jeans from
know, China
to provide you
with the goods
Shoes from
and services Kenya
you enjoy.
 Interdependence

^ Trade can make

everyone better off ^

▪ It is why people – and nations – choose

to be interdependent

▪ How they gain from trade?

 Absolute Advantage
➢ Adam Smith: The Wealth of Nations, 1776
➢ A country
– Should specialize in production of and export products for
which it has absolute advantage; import other products
– Has absolute advantage when it is more productive than
another country in producing a particular product

A country has an absolute

advantage in something if they
can produce more of that
product than their trading
partners can with the same
amount of inputs (production
factors/ resources)
 Absolute Advantage
Ability of a nation to use its resources to
produce a good/service more efficiently than
any other nation (greater output using same or
fewer resources)
Riceland Tealand

1 resource unit = 1 ton rice or 1 resource unit = 1/6 ton rice or

1/5 tons tea 1/3 tons tea

Specialization and trade allow each to

produce and consume more
 Absolute Advantage
Using a package of production factors in particular time,
Thai can produce 100 durian or 50 manggo, and Viet can produce
75 durian and 25 manggo.

Durian Manggo
Thai 100 50
Viet 75 25

• Thai produce more in durian (100) than Viet (75) → Thai

has absolute advantage in durian
• Thai produce more in manggo (50) than Viet (25) → Thai
has absolute advantage in manggo
• In short, Thai has absolute advantage in both products
 Which country has an absolute
advantage in producing each product?

1. The US can produce 20 planes

2. France can produce 12 planes

1. Korea can produce 3 cars or 9 motorcycles

2. Germany can produce 4 cars or 8 motorcycles

1. Japan can produce 4 laptops or 12 phones

2. Brazil can produce 1 laptops or 5 phones

1. Cuba takes 4 hours to make a TV and 12

hours to make computer
2. Mexico takes 1 hour to make a TV and 5
hours to make computer
 ANSWER
⚫ The US has an absolute advantage in production of
plane

⚫ Korea has an absolute advantage in motorcycles

⚫ While Germany has an absolute advantage in cars

⚫ Japan has an absolute advantage in production of

laptops and phones

⚫ Mexico has an absolute advantage in TV and

computer since it can produce same amout of TV and
computer using less resources
 COMPARATIVE ADVANTAGE:
One nation can produce a good at
a lower opportunity cost than
the other

• The opportunity cost of a good

or service is its cost in terms of
the forgone opportunity to pursue
the one best possible
alternative activity with the
same time or resources
 Trade and Comparative
Advantage
⚫ Adam Smith argued that humankind’s
proclivity to trade leads to individuals using
their comparative advantage.
⚫ Markets allow specialization, leading to
trade and growth.

⚫ What are countries have to give

up to produce a product which
has/not an absolute advantage? →
comparative advantage
 Specialization
• Economic actors will be better off if they
choose to produce those things for which
they have the lowest opportunity costs, and
trade for those with higher costs.
– This is called specialization.
• Choices based on lowest opportunity costs
involve giving up the least amount of other
things.
Specialization is based on
Comparative Advantage!
 Comparative Advantage

To identify the comparative advantage, you

must to :
1. Calculate the opportunity cost for
producing one of each product
2. Identify which country has a comparative
advantage in producing each product
 Comparative Advantage:
Example 1
1. The US can produce 20 planes
2. France can produce 12 planes
Answer these questions
1. Calculate the opportunity cost
for producing one of each
product
2. Identify which country has a
comparative advantage in
producing each product
 Comparative Advantage:
Example 1
1. The US can produce 20 planes or 2 cruise ships
2. France can produce 12 planes or 2 cruise ships
Planes Cruise
US 20 2
France 12 2

Answer these questions Hints

1. Calculate the opportunity cost for 1. How much one plane cost
producing one of each product and one cruise in US and
France?
2. Identify which country has a
2. What nation can produce
comparative advantage in
a good at a lower
producing each product
opportunity cost?
 Comparative Advantage: Example 1
Planes Cruise
US 20(1P cost? 2(1C cost?
France 12(1P cost? 2(1C cost?

Planes Cruise
US 20 2
(1P cost: 2C/20P=1/10C) (1C cost: 20P/2C=10P)
France 12 2
(1P cost: 2C/12P(=1/6C) (1C cost: 12P/2C=6P)

Concept: How much each one cost

 Comparative Advantage: Example 1
Planes Cruise
US 20 2
(1P cost: 1/10C=0.1C) (1C cost: 10P)
France 12 2
(1P cost: 1/6C=0.16) (1C cost: 6P)

Answer these questions

1. What is the opportunity cost for producing one of each
product?
2. Who has a comparative advantage in plane?
3. Who has a comparative advantage in cruise?

Comparative advantage: One nation can produce a

good at a lower opportunity cost than the other
INDIVIDUAL HOME WORK #1
CDs Pounds of beef
India 4 2
Canada 4 6
1.Which nation has a absolute an advantage in
producing CD’s?
2.Which nation has a absolute an advantage in
producing beef?
3.Which nation has a comparative advantage in
producing CD’s?
4.Which nation has a comparative advantage in
producing beef?
5.Should India specialize in CD’s or beef?
6.Should Canada specialize in CD’s or beef?
INDIVIDUAL HOME WORK #2
Cars Computers
Korea 12 4
Japan 10 6
1.Which nation has a absolute an advantage in cars?
2.Which nation has a absolute an advantage in
computers?
3.Which nation has a comparative advantage in cars?
4.Which nation has a comparative advantage in
computers?
5.Should Japan specialize in cars or computers?
6.Should Korea specialize in cars or computers?
INDIVIDUAL HOME WORK #3
Apples Rice
Fiji 10 5
China 10 2
1.Which country has an absolute an advantage in
apples?
2.Which country has a absolute an advantage in rice?
3.Which country has a comparative advantage in
apples?
4.Which country has a comparative advantage in
rice?
5.Should Fiji specialize in apples or rice?
6.Should China specialize in apples or rice?
Submit the Home Work next week (hand
writing), due on Tuesday, 12 March 2024 at
11 am
 The Benefits of Trade

⚫ When people trade, both parties

expect to benefit from the trade.
⚫ Otherwise, why would they have
traded in the first place?
 The Benefits of Trade

⚫ The argument for the benefits of

trade underlies the general policy of
laissez-faire.
⚫ Laissez-faire – an economic policy of
leaving coordination of individuals’
actions to the market.

Laissez-faire is an economic system in which

transactions between private parties are free
from government intervention such as regulation,
privileges, tariffs, and subsidies
 Production Possibilities
without Trade
⚫ Pakistan can produce 4,000 yards of
textile per day or 1 ton of chocolate
per day.
⚫ Belgium can produce 1,000 yards of
textile a day or 4 tons of chocolate
per day.
Pakistan and Belgium without trade
Textile per day Chocolate per day
Pakistan 4,000 yards 1 ton
Belgium 1000 yards 4 tons
 Production Possibilities
without Trade
Pakistan’s and Belgium’s Individual Possibilities
Textile per day Chocolate per day
Pakistan 4,000 yards 1 ton
1T=1/4000=0.00025C 1C=4000/1=4000T
Belgium 1000 yards 4 tons
1T=k4/1000=0.004C 1C=1000/4=250T
⚫ Pakistan has a comparative advantage in
producing textiles.

⚫ Belgium has a comparative advantage in

chocolate.
 Production Possibilities
without Trade

5
(in thousands of yards)

4
Pakistan
Textiles

2
Belgium
1

1 2 3 4 5
Chocolate (in tons)
 Production Possibilities
without Trade
⚫ Pakistan has chosen to produce 2,000
yards of textiles and 0.5 tons of
chocolate.
⚫ Belgium has chosen to produce 500
yards of textile and 2 tons of
chocolate.
 Production Possibilities
without Trade
Pakistan’s and Belgium’s Individual Possibilities
Textile per day Chocolate per day

Pakistan 2,000 yards 0.5 ton

Belgium 500 yards 2 tons
Total 2,500 yards 2.5 tons
 Production Possibilities
without Trade

5
(in thousands of yards)

4
Textiles

Pakistan
3 C
A
2
Belgium
1 B

1 2 3 4 5
Chocolate (in tons)
 Production Possibilities
without Trade
⚫ Point A: The combination of textile
and chocolate chosen by Pakistan.

⚫ Point B: The combination of textile

and chocolate chosen by Belgium.
⚫ Point C: The joint combination
without trade.
 Production Possibilities
without Trade
⚫ The two extreme combinations are
both countries producing only
textile (point D) and both
producing only chocolate (point E).

⚫ The combined production possibilities

curve with no trade is drawn by
connecting these two points.
 Production Possibilities
without Trade

D
5
(in thousands of yards)

4
Textiles

Pakistan
3 C Joint (no trade)
A
2
Belgium
1 B
E
1 2 3 4 5
Chocolate (in tons)
Production Possibilities with
Trade
⚫ Point F: This is where each nation is
focusing on that activity for which it
has a comparative advantage.
⚫ Pakistan produces 4,000 yards of textile.
⚫ Belgium produces 4 tons of chocolate.
Production Possibilities with
Trade

Combined Production Possibilities

Specializing Gains to
No Trade
and Trade Trade
Fabric
2,500 yards 4,000 yards 1,500 yards
(textile)
Chocolate 2.5 Tons 4 tons 1.5 Tons
Production Possibilities with
Trade
D Gains from trade
(in thousands of yards)

5 Joint (with trade)

4 F
Textiles

3 C Joint (no trade)

2

1
E
1 2 3 4 5
Chocolate (in tons)

⚫ The combined PPC is bowed out because of Point F –

comparative advantage and specialization.
 Summing up
⚫ Specialization leads to higher
production
⚫ Everyone has different Opportunity
costs, everyone has comparative
advantage/disadvantage in
something.
⚫ It is comparative and not absolute
advantage the basis for mutual gain.
THE END